How One Hedge Fund Solved Low Volatility

By

Steven M. Sears

July 18, 2017 5:31 a.m. ET

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It’s one of the most contentious debates in the investment world: What happened to stock market volatility?

On most days, almost nothing happens in the stock or volatility markets. The Standard & Poor’s 500 index usually moves less than 1% from open to close. The primary proxy of equity volatility, the CBOE Volatility Index, or VIX, seems limp. It was recently around 10, far below its long-term average of 19, implying massive profits can be made when VIX returns to a normal level.

The absence of intraday market volatility, some contend, is the financial equivalent of a calm before the storm that will poleaxe stocks. What might cause that to happen to stocks—or for the VIX to surge again—is anybody’s guess. So far, both seem immune to risks that should knock them off balance, including rising U.S. interest rates, terrorist attacks, and political turmoil like the United Kingdom’s planned exit from the European Union or the investigation into President Donald Trump’s alleged campaign collusion with Russia.

While others argue about it, Joe Aiken and Jake Weinig have found a way to profit from it. The pair run Malachite Capital Partners, a hedge fund that specializes in trading volatility. So far this year, the $300 million fund is up about 12%, compared with about 9% for the S&P 500. In 2016, the fund returned 22.3%, compared with 9.5% for the S&P 500.

Such market-beating returns in a low-volatility environment are tantamount to pulling rabbits out of a hat.

The stock market will inevitably decline from these historic highs, but that doesn’t much matter to Malachite’s managers. They analyze volatility and use sophisticated strategies to extract the stock market’s risk premium while insulating themselves from its moves. Before they started their hedge fund in 2014, Weinig ran Goldman Sachs’ institutional derivatives sales and Aiken designed algorithmic trading strategies for the investment bank’s clients.

Manager’s Bio

Malachite Capital

Name:

Joe Aiken

Age:

35

Title:

Founding partner and portfolio manager, Malachite Capital Management

Education:

B.S. in mathematics, York University; M.S. in computational finance, Carnegie Mellon University

Hobbies:

Math, reading, football, Toronto Maple Leafs hockey

Since the 2008 financial crisis, major banks and investors have looked at volatility as an asset class like stocks and bonds. Many wealthy investors and institutional funds are also increasingly allocating part of their portfolios to volatility. When stocks fall, for example, volatility rises, which often has a positive impact on longer-term investment returns.

The most-common way most investors harness volatility is to buy bearish put options on major indexes, including the S&P 500 and the Nasdaq 100. Many mutual fund managers also routinely sell upside calls against their stocks, effectively getting paid in advance just for agreeing to sell stocks at their target, or exit, prices. Investors of all persuasions trade VIX options and futures.

Malachite Capital uses more-complicated strategies that reflect Aiken’s and Weinig’s tradable views on how volatility is influenced by various factors, including supply and demand imbalances within markets, and even regulatory mandates that affect how banks commit capital to their clients. This is their first interview with Barron’s.

Barrons.com: Is volatility really as low as it seems?

Aiken: Low volatility is different than cheap volatility. Realized volatility—what has actually happened in the market—is the lowest it has been in 50 years, but the market price of volatility, which is to say the expectation of volatility in the future, is much higher than most people realize.

How do we know this? Anyone who has bought S&P 500 options to hedge their stock portfolios has likely lost money. If you bought a one-week straddle—that is, a put and call with the same strike price that expires in one week—the hedge has consistently been a money loser over the last several months. Why? Because dealers are selling those straddles, which is to say volatility, at a higher level than the market has been moving.

Q:What would it take for volatility to really spike and break the cycle?

Weinig: It could be any number of things. Low-volatility regimes are broken for reasons including the economic cycle turning, a typical bear market, a major corporation’s bankruptcy or fraud—think Enron or WorldCom—or a massive terrorist attack, war, or some kind of geopolitical event, or any shake-up in the government.

Q:Perhaps that’s why so many investors are eager to position for volatility rising. What’s a smart way to do that?

The first fund is a leveraged version of a VIX futures index that is rolled each month as the futures contracts expire. The funds are basically a way to trade the volatility of volatility. But our position—we are short UVXY and short SVXY—makes us market-neutral volatility on Day One of the trade. But for each day after, we are exposed to the mean reversion of volatility.

One way to think about volatility is to imagine that it is a rubber band that stretches out and returns to its resting state. So choppiness in volatility is the best environment for that trade.

More From Barron’s

Weinig: The traditional view is that there is a negative correlation between equity markets and volatility. In other words, this means that volatility moves in the opposite direction of the stock market—which is true most of the time, but not always. But what investors have to really understand is that volatility is a short-term investment. Whereas equity investments may be very long term, most of these volatility products are not meant to be buy-and-hold investments.

The first thing investors should try to understand is separating equity returns and volatility returns. The creation and proliferation of VIX products has allowed investors to take pure views on volatility.

For example, if you wanted to wager that VIX would rise, you can do any number of things. You could buy short-term options or calls or call spreads on VIX, or you could buy something like the iShares S&P 500 VIX Short-Term Futures ETN. The issue with VXX is that it is a fantastic investment over the next two weeks, or one month, but VXX is not a fantastic investment if you think volatility will rise over the next six months. This is because the portfolio rolls futures contracts, and that introduces other factors besides the price of the VIX, including term structure and contango. Even if all futures rise, your portfolio performance will be based on that and the average difference between the front month and second month. There is more to it than just the price. You have to understand how the underlying portfolio functions.

Q:People say volatility is low, but it seems they are oversimplifying something that is nuanced and has more moving parts than is generally understood.

Aiken: You have to focus on the difference between realized and implied volatility. This is another way to determine if volatility is truly low, or if volatility is being misrepresented by people who don’t understand volatility. Realized volatility is an historical measure of how much the market has actually moved on a close-to-close basis, and implied volatility is simply a forward measure of what the market expects.

On the S&P 500—and this is true now and throughout history—there has been a large spread between realized volatility and implied volatility because most investors buy index options to insure their stock portfolios, and this helps to increase the implied volatility of those index options. We track realized and implied volatility, and we are always looking at the spread between the two to help us determine if we think volatility is rich or cheap. As we said earlier, VIX may be low, but volatility is not cheap.

Q: What’s your take on VIX? It’s commonly referred to as the fear gauge, but it doesn’t seem to be registering any fear. Does VIX matter anymore?

Weinig: VIX completely matters, and more importantly, I will make the argument that VIX is not particularly low. VIX is doing exactly what it was meant to do. People will argue that VIX is no longer relevant, or just too low to have any meaning, but VIX is purely meant to be a function of the price of volatility for the next 30 days. Another way of saying that is that VIX reveals what is the stock market’s expectation for what volatility will be. When VIX is low, the stock market expects the low volatility regime to continue, at least for the next month.

Now VIX is saying there’s not a lot of fear. Anytime we’ve had any sort of dip, we’ve had buyers coming back into the market. There is no fear of a loss, and because of that VIX is low, but not necessarily cheap. Buyers of VIX have continuously lost money this year even though VIX has been low.

There has been historically a substantial supply and demand imbalance in S&P 500 options; there is typically more of a demand to buy volatility than to sell volatility. And that imbalance will drive the implied versus realized volatility spread. We are always tracking that imbalance to identify instrument prices that reflect an opportunity.

Aiken: The key for investors—and this is what we spend an enormous amount of time doing—is understanding flows, positions, and product innovation. To simply view volatility as an insurance product, or as a negatively correlated asset to equity markets, is how people get hurt. Volatility does act like that daily, but having a view on global positioning is the real key to success in this space. The supply-and-demand forces within volatility are almost as powerful as actual market forces within volatility.

The landscape in derivatives products is always evolving, and the great opportunities of 10 years ago are different than five years and for today, and they are different than what will exist tomorrow. So that’s what drives where the most attractive pockets will be. It’s not a fire-and-forget market. People say equities go up in the long run, but there’s nothing like that in volatility where a passive investment approach can succeed.

Q: Thank you for sharing your insights.

STEVEN SEARS is the author of The Indomitable Investor: Why a Few Succeed in the Stock Market When Everyone Else Fails.

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